I didn’t understand tax brackets until a couple years ago. I have been doing my families taxes (through Turbo tax and now a local tax preparer) for the last decade and I still didn’t really understand brackets. Tax brackets are not like trees. The real question is not how I climbed this tree in Mrs. Dooley’s yard, but how did I make it down? Here is a short and painless video that explains tax brackets in the United States. I also didn’t quite understand with-holdings and how many to take. I realized that how many with-holdings you elected determined how much $ was taken from your w-2 income and sent to IRS. We used to receive several thousand dollars back after filing taxes, it was like a bonus! Then I realized it is also an interest free loan I’m giving to Uncle Sam. This year, 2020, we owed a few hundred dollars after filing our taxes. As you can see, I haven’t perfected getting close to owing 0 and being refunded 0. #lifegoals .
I discovered in late 2018, from episode 13 of the Choose FI podcast, when the Millionaire Educator was interviewed, that we can choose how much we will pay for taxes. There are tools available that can help us reduce our tax liability in a given year. The tools I have used for a few years are Daycare FSA, Health FSA. The Flexible Spending Accounts(FSA) are accounts with a set amount of $ taken out of my paycheck pretax that I spend on daycare and health related expenses – downsides are if you don’t use the amount within a certain time frame you lose it. After listening to this podcast, I learned I also have the pretax accounts available to me called 403b and 457b, and my loverly has a 401k. There are also many tax benefits related to having your own business, which I may use in the future.
In this world nothing can be said to be certain, except death and taxes.
On the Millionaire Educator’s website, his most looked forward to post of the year, is the tax planning post. You can find 2020’s post here. Millionaire Educator has a unique way to look at taxes and works out using standard deductions and child tax credits, how much you can earn to be in each tax bracket. I read the post and found my situation, married filing jointly with two kids.
Now, when you are paying off debt, such as student loans, car loans, mortgage, consumer debt, you pay with income you have paid taxes on. There is a certain amount of expenses you have every year, the greatest categories for folks like me tend to be Housing, Daycare, Food. I will get into our yearly budget in another post, and knowing what you spend in a year is important because it helps you plan, informs you, points out where there may be room to change. Let’s give a hypothetical. If my family earned $160,000 in a year and spent $120,000 that means I have $40,000 I can put in pre-tax vehicles. For my family, that may mean I put $5000 in my daycare FSA, $1000 in my health FSA, $10,000 in Loverly’s 401k, and I have $24,000 left to max out ($19,500 in 2020) one of my accounts (403b,457b) and put the remaining $4,500 in the other, or some other breakdown allocations. Here are two pdf links describing the different plans 403b and 457b.
From the chart below, what I find amazing is that my family can earn $105,050 for tax year 2020 and still be under the 22% tax bracket. I can see I’ll pay $5,235 in taxes and that my overall rate of taxes paid to income taxed on is under 5%, that, my friends, is pretty awesome! With this knowledge, I realize anything earned over $105,050 will be taxed at the 22%, 24%, 32%, etc. tax brackets.
What would you do with an extra $3895? or $12,695? These different amounts are nothing to sneeze at.
Let’s say I have less debt and therefore my yearly budget is less, I pay off my mortgage and taking out the principal and interest, I reduce my budget by $20,000. My family still earns $160,000 and now my yearly expenses come out to $100,000. This means I have $60,000 in my budget I could potentially funnel into pre-tax vehicles.
The difference in taxes on the $160,000, if I don’t use any pre-tax advantages, I would pay $17,324 in taxes. If I reduce my taxable income to $120,000 by using pre-tax advantages I would pay $8524 in taxes. If I reduce my expenses further to enable more to be put in pre-tax accounts, with a taxable income of $100,000, I would pay $4629 in taxes. These different amounts are nothing to sneeze at. In a peripherally related topic, I really like this video as a reminder every so often.
To be honest, the last two years is the first time I have even thought about strategy and taxes. I do think we citizens should pay taxes, that we should contribute to the services that help our society run. I am by no means advocating not paying taxes in shady ways. Uncle Sam will get his dues one way or another.
Now, for the daycare FSA and health, FSA, as long as I use the money for covered expenses, I have effectively given myself a 22% discount since I did not pay tax at my highest rate on those items, I find this to be a great deal if I can plan these expenses accurately. The money I have put into 401k, 403b, and/or 457b accounts is pre-tax now, and when I draw the money out of these accounts in the future I will pay taxes on them. I do not know what tax brackets will be in the future. When I draw these accounts down I will likely not have dependent children (with the nice tax credits). Everyone’s situation is unique. I find it so interesting that we can choose how much we pay in taxes, to a certain extent.
So, what would you do with an extra $3895? or $12,695?
As ever, SOS
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